Performance Metrics Fundamentals

The Basics

Selecting the optimal performance measure(s) for executive compensation or other business purposes starts with an understanding of the most common measures and their respective strengths and limitations.

The Most Common Types of Performance Measures

There are two broad categories of performance measures most often used in executive incentive plans: financial measures and market measures. Financial measures are those that are based on the underlying financial statements of a company, while market measures are based on stock price and/or dividend results of the company. (Operational measures, a third category, are not as common in incentives except in short-term incentive plans for certain industries.)

I. Financial Measures

Financial measures can generally be broken down into three categories, profit, return on investment and growth, as shown below.

II. Market Measures

Market measures are stock price-related metrics. Stock options and restricted stock derive their value directly from stock price and the change in stock price. The most common market metric for performance plans is relative total shareholder return (TSR).

TSR = Change in stock price plus dividends / beginning stock price

Since TSR is a stock-price based metric, it is volatile. Moreover, since it is impacted by many external as well as company-specific factors, rarely are TSR goals set in terms of absolute TSR. Rather, TSR is nearly always measured relative to a relevant comparator group. Applied in this fashion it can screen out or neutralize external factors impacting stock price, i.e., those factors that may tend to impact companies to one degree or another in comparable ways.

The Details

Profit Measures Defined

• Net income = bottom line profitability after all sources of income and expenses are included.
• EPS = bottom line profitability per common share outstanding.
• Operating income = Revenues less normal operating expenses (excludes interest, taxes and non-operating revenues and expenses).
• EBITDA = Cash-based operating income. Excludes interest, taxes and non-operating revenues and expenses and also non-cash expenses such as depreciation and amortization.

Return on Investment Measures Defined

All return measures attempt to characterize profitability as a percent of a certain measure of investment, i.e., “what did we get for what we put in?”

• ROIC = Net operating profit before interest expense / (Total debt + total equity)
• Return on assets = Net operating profit before interest expense / Total assets
• Return on equity = Net income / Total stockholders’ equity

Return on net assets (RONA), return on capital employed (ROCE), and return on gross investment (or gross assets) are all close variants of ROIC and ROA.

Growth Measures Defined

Value creation is about balancing profitability and growth. Strictly speaking, growth measures are those that help quantify the expansion of the scope, reach and depth of an organization. Growth metrics are focused principally on changes in size, not changes in profitability. Although profit metrics sometimes are characterized as growth measures, they are really variations of profit measures. Therefore, the two most common growth metrics are:

• Revenue growth = Year-over-year or multiyear change in sales of the company.
• Asset growth = Year-over-year or multiyear change in total assets of the company (common for financial firms or in more specialized natural resource applications).

Market Measures Defined

As noted, market measures are stock price-related metrics, often including dividends as well.